Wednesday, 20 April 2016

On the economics of Brexit, and an argument that the UK would have been better off outside the EU

The UK Treasury recently published a report detailing the costs to Britain of leaving the EU.  It has been generally praised by economists, who take it for granted that the economics of Brexit would be bad for the UK.

I have a problem with this report, and actually I have a problem with the assumptions that are taken for granted and underpin it.

I would like to make clear that I think that it is very likely to be better for the UK economically to stay in the EU. I think that the risk of disruption on Brexit would be large, that regulatory changes would cause extra work and that investment would suffer under the uncertainty of the future regime. Financial services, for example, could be damged by the change in jurisdiction. A vote to Remain is the safe vote and sensible vote. However this does not mean that one should take for granted that the long term result of Leave would be detrimental.

Reading through the Treasury report, the first thing that struck me was the one sided nature of the language. Facts are cherry picked. Examples of damage to the UK are constantly given, along with the advantages for future growth of the Cameron negotiated settlement, which would be lost if the UK left. But nowhere is the opposite side given. Most consequences have winners and losers, and the Treasury is only listing the losers.

As a small and trivial example, at one point it talks about the possible end to Duty Free. It describes how UK consumers will no longer be able to get cheap alcohol when coming back from holidays. This is undoubtedly a bad thing for alcoholic British holidaymakers, but actually this is also a good thing for UK retailers who can now sell the alcohol at home. It is also a good thing for the UK Treasury which receives the extra duty. The one sided nature of the analysis is apparent throughout the whole report.

As a larger example where consequences are less obvious, consider the following hypothetical scenario. Brexit causes an increase in financial regulation in which half the finance industry is lost. UK GDP would go down by around 5% as this contributor to GDP was lost. However, this is not the whole story. What do the bright, educated people who lost their job in finance do next? Eventually they find other jobs. How much of that loss of production is replaced by the financiers now working in other industries? This is far from clear, but it is wrong just to focus on the 5% figure. The Treasury approach appears to be to focus on the definite negatives without taking account of the compensatory positives that an economy does in adaptation to new conditions.

In the late 1700s and early 1800s, the UK had a problem, in that it very high wages relative to the rest of the world. If a Treasury report had been made into these high wages it would undoubtedly have pointed to this source of lack of competitiveness and suggested ways to reduce the wages in order to compete in the high labour intensity work that characterised the world economy at the time.

But what happened instead? The combination of high wages with low coal costs combined to make the early stages of the Industrial Revolution financially viable. The high wages in the UK meant that Britain was the first to industrialise and became the largest economy in the world. But this could never have been predicted just from looking at the high wages in 1790.

The point I am trying to make is that the economy adapts to new scenarios so using theoretical models does not necessarily help to illuminate the reader.

The report states, with well defined error bounds, that the expected loss to the average household in the UK in the case of a negotiated bilateral agreement is around £4,300. It does not take into account disruption here, and is based on the lost benefits of free trade, free movement, joint regulation etc. My first thought is, how can I test if this makes sense.

A simple common sense one: A 10% increase in tariffs across the board is equivalent to a 10% stronger pound for exporters. Since pound has gone both up and down by more than 10% in the last few months without dire consequences, this strikes me as not of huge significance.

If the Pound were to go down by 10% on Brexit due to withdrawal of investment from the UK, with tariffs rising by 10% at the same time, then exporters would be no better or worse off than before. Imports would be a lot more expensive and the current account would go into surplus instead of the current constant deficit. The floating exchange rate would cushion much of the economic impact - the UK would be poorer but  a) not in Pound denominated terms and b) only because it would be paying back some of the money it has been borrowing from the rest of the world.

I looked for empirical evidence of the effect of higher trade barriers on growth. I found this interesting paper. It suggests that for poorer countries, higher tariffs are, if anything, beneficial. For richer countries they are detrimental, but the size of this effect is nowhere near the sort of effect the treasury expects, and is of the order of 0.1% or 0.2% per year.  George Osborne has single handedly, through his policies of austerity cost the UK at around 1.5% per year in my opinion. Which puts Brexit at approximately 10% as damaging as Osborne.

The next test I did was to look at UK real GDP growth relative to the United States. In the period between 1946 and 1973 the UK grew at an annualised rate of 3.2% compared to the US at 3.7%. After joining the EU what would one expect? Could there be catch-up where the UK grows faster than the US? Maybe it just grows at the same speed. At the very least it should keep the same gap between the growth figures.

In fact the gap widened. In the period from 1973 to 2014, the US grew at 2.7% annualised, with the UK in the European Common Market growing at only 2%. This is extremely disappointing especially given all the clear and obvious stated benefits of free trade in the EU.

I know that this is one number and there is a lot more to it than that, but it is a pretty important number and surely this should warrant further analysis to explain why if the common market was so great, we've actually had a relative reduction in growth.

I would like to propose a possible reason for this, and once again it comes down to the unexpected consequences I describe above, and the adaptation of economies to underlying conditions.

Why is free trade good? Because it allows specialisation. If one country is slightly better at making cars and another is slightly better at making motorbikes then, if the two countries have free trade, one can concentrate on making only cars and the other on making only motorbikes. This means that between the two countries they maximise the production of cars and motorbikes, and both end up cheaper to the end consumer.

If tariffs existed, then both countries would produce both cars and motorcycles but not as efficiently as they would be partly working on something that they are worse at.

Where could there be a flaw here? Well, there are no fiscal transfers between the two countries. So supposing motorcycles go out of fashion and no-one buys them. Motorcycle country now has no industry and will have to start a new industry to replace it. This takes time and involves unemployment and retraining. The floating exchange rates between the two countries softens the blow but it is still painful.

If both countries had tariffs then the pain would be shared. If both had been part of the same country then money from the car producers could go to help the motorcycle producers. But free trade with no fiscal transfers means that each country is at risk from the specialisation it ends up having being out of fashion.

This is a general argument against free trade, but specifically I think that his may have hurt the UK in the following way.

The UK has a highly educated workforce, speaks English, has low financial regulation and sits in between the US and Asia in terms of time zones. It is the perfect combination for a financial centre. The UK thus has a competitive advantage in financial services and it brings a great deal of export revenues into the country from selling these services abroad.

That sounds great, but actually maybe it isn't. The success of financial services means that the UK Pound rises in value. This means that UK manufacturing, for example, now becomes less competitive against other countries in Europe. Because there are no tariffs there is nothing to stop UK residents buying their goods from Germany and services from the UK as this works out cheaper. Had there been tariffs then Germany would have done more financial services and the UK more manufacturing.

The result of all this is that the UK ends up specialising in financial services more than it otherwise would have done as other industry atrophies due to being uncompetitive. Other EU countries specialised in other industries - and ones that in fact are less cyclical and with more durability.

In 2008, the UK paid the price for specialisation in finance. Finance means high leverage. The cost to the UK people of the finance industry was very large. And then larger than this, the cost of the policies of austerity which followed damaged the UK economy significantly.

I am a big supporter of immigration, but another possible way that EU membership may have damaged the UK economy is through freedom of movement bringing down wages in the low skills end of the market. Traditionally economists would say that this is a good thing. But what if the low wages meant that (in an opposite way to the high wages 200 years before) low skilled jobs were not automated. People are cheaper than machines and hence productivity is damaged. High wage economies have higher productivity. Maybe if the UK had more regulation and less immigration we would have had productivity as high as our European counterparts.

So maybe EU membership and free trade actually damaged Britain. These are just musings; counterfactuals are always impossible to be sure of. But what is definitely true is that the economy adjusts to things in unpredictable ways. Low wages may be good or bad. High tariffs may be good or bad. Leaving the EU could, for example, result in the UK becoming a powerhouse in high end technology. Or could result in a £4,300 loss per household. We just don't know.

So, in conclusion, what happens if the UK leaves the EU?

I don't know but I do feel that it definitely can't be summed up in a report with definitive numbers and precise error bounds.


It is often stated that EU membership has provided great economic benefit. Most major economic institutions support this theory. However, there is no paper that I have read that has adequately shown this.

As an example, Chris Giles, in the FT, points to this paper which he calls an example of 'the best economic studies'. It states that the UK is roughly 10% better off than it would have been outside the EU. This paper bases its conclusion on two types of model.

The first is a gravity econometric model that looks at the increase in trade and assumes economic improvement. In my opinion, when increased trade and increased GDP are not proven to be causally linked this model based approach is not enough.

There is little doubt that for a small isolated economy, an increase in trade will on average improve economic growth. But does this effect continue indefinitely? Is it not possible that after a certain level of trade, further increases do not improve economic growth?

A better way is to look at actual results and compare to the closest comparators. This is the approach of this paper, also cited. This would be a very valid approach, however it appears that the data period is cherry picked, ending in 2008. This both removes the effect of the Euro crisis and also, as it measures growth as GDP in US dollars, it stops at a time when the Euro was at an all time high against the dollar. It makes the growth of Euro and £ economies look higher. Also, the estimate is very dependent upon the choice of comparator country weights.

To test if this paper is valid, I did my own test. I looked at real GDP growth for ALL EU countries against ALL high income countries using the world bank database. This is a real aggregate test, that does not allow any cherry picking.

The graph is below.

You can see that up until the Eurozone crisis, EU economies grew exactly in line with other high income economies. There is no discernible benefit from having an increased freeer trade zone. The only difference comes when the Eurozone crisis hits when, for reasons I discuss here, Eurozone countries underperform.

To everyone who says what a great economic boost it has been to be in the common market, I would ask them to explain this graph.

Incidentally I did ask this to the author of the paper above. But received no reply.

As a final aside, there is one major benefit that the UK does receive from being in the EU. It is that it does not allow the more libertarian UK politicians to erode worker rights and opt out of anti-discrimination policy.

The free market is a great thing in that it means that more gets produced of what people want, and less of what they don't want. But when it pushes down wages and increases corporate profits, as well as leading to a rise in corporate and individual debt, it becomes a damaging system. The UK has long been a major proponent of the more laissez-faire ideal of the free market and this leads to an unbalanced and hollowed out economy.

For this reason I think the UK is probably be better off in the EU. But it is definitely not due to the fear of job losses, interest rate rises and even war invoked by Osborne, Cameron et al.


  1. I had been waiting for a more nuanced perspective. This is great

  2. It was due to EU competition law chapter 25 and section 75 which stipulates competition within healthcare,that policy pushing privatisation and competition was entered into the 2013 Health and Social care act. This is putting at risk the nature of our public National Health care service.As a result of European competition legislation the Royal Mail was privatised and sold off to Osborne's City associates.The EU is behind the Common Agricultural Policy which is a subsidy for for the landed wealthy and boosts land prices,to the detriment of the less wealthy.The EU is behind TTIP.British Rail was privatised due to EU legislation European Commission rail directive 91/440/EEC.Want to rescue tolbort steelworker?EU legislation prohibits that. Immigration from Baltic and Poland has pushed down wages for low skilled jobs.leaving the EU could put the financial service sector at risk?....well that's is probably a good thing.The EU has been atrocious to Greece.Brussels has been institutionally set up to serve Banks and private corporate interests just like Tony Benn said.The consequences may be uncertain,but a vote to leave is a chance to register our disapproval.

    1. Hi Jake,

      I have many problems with the EU. The handling of the refugees and Greek crises have been terrible. The bureaucratic overreach and dysfunctional decision-making process are both awful. But also there are undoubted benefits to the UK membership. And there is a lot to like (to me) about the ideals of cooperation, free trade, free movement and human rights. And there is no real question that leaving would be disruptive.

      Really honestly I don't know what the best option is.

  3. The EU Common Agricultural Policy seems designed to put farmers out of business, especially those in the southern countries. One example: the EU inspectors had found that Italy's olive trees carried a dangerous parasite and Italian olive growers were ordered to destroy their groves in order to stop the spread of the parasite. Recently an investigation initiated by the Italian police found no such danger and the felling was stopped, but not after thousands of trees were destroyed.
    Another case: the EU recently ordered that produce from north African countries could enter Europe duty-free, in spite of the fact that it is grown using pesticides whose use is prohibited to European growers and that labour costs in those countries are a fraction of those in the EU. The same goes for oranges from Argentina and various foodstuffs from China.
    This has caused the shut-down of thousands of small and medium size farmers in Italy. The situation is similar with regard to milk products for which the quota regime makes production cheaper in northern EU countries - again thousand of dairy farms have gone bankrupt in the southern countries, with the further consequence of the loss of skills for the future.
    These EU policies seem to be designed as preparation for Monsanto. Out go the small/medium farms, in comes the giant. Control the food and you control the world.

  4. Jake. There is nothing in EU legislation that requires private ownership of utilities. You have been misinformed on the postal and rail privatizations. The same is also true of TTIP.

  5. @GuyJenkinson , erm how so? looke up EU directive 94/440 and EU legislation on directives 97/67/EG and 2002/39/EG.The CAP is an atrocious transfer of Wealth.State aid/nationalisation i snot allowed.TTIP is a back door for private interests.The Eurozone is an austerian rightist economic nightmare/dream.


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